RE: Care to give me a hand?

Here are a few of my responses from the comments on yesterday’s blog post. My questions to you were:

How do you think mutual fund money managers and Wall Street brokers and pros make these all-important decisions?

Are they just guessing? Shooting blind? Or do they have tested, reliable ways to structure portfolios that truly do minimize your risk while maximizing profit potential?

Lincoln Rowley – 01.20.10 at 11:07 AM

Martin et al.

While the fund managers and brokers (in theory) have research analysts to pull apart a company’s reported information, and gain insight to given industry groups, when it comes down to it – they too are acting on ‘gut’ to make their calls. There is too much incentive on wall street to follow the ‘consensus estimates’ and stake your claim slightly to the above or below the consensus. Worse yet, the firms that rely heavily on programmed trading, technologically institutionalize the expected behaviors of the herd in response to news or market moves – which is way more dangerous than if they were all making gut calls.

The only true standouts in the industry are the ones who DO THEIR HOMEWORK, work harder than the rest on gathering information, challenging their own assumptions, and evaluating the sensitivity of their decisions to those assumptions. It is that hard work that generates the confidence to make a stand against the consensus, bet that way, and make real returns over the long run. I pay Weiss Research for that hard work, and on days like today (1/20/10) when the market is moving against many of those recommendations, I place my bets based on that intellectual discipline, and I make money.

Lincoln, very well said! The herd psychology on Wall Street has been well documented, and, most never seem to learn the lessons of history. Even after two great bear markets in the past ten years stocks, stock analysts rarely issue “sell” ratings. The “S-word” — not the F-word — is what’s truly taboo among brokers. And ironically, most of Wall Street is a victim of its own propaganda: The pros themselves get caught in market declines just like everyone else.

Research, analysis and recommendations are almost universally skewed to the bullish side — a bias that works in long-term bull markets like the 1990s but can be fatal in seesaw markets like the 2000s. — Martin

John Santa Cruz – 01.20.10 at 11:26 AM

How do you think mutual fund money managers and Wall Street brokers and pros make these all-important decisions?

Mutual fund money managers and Wall Street brokers and pros make these all-important decisions by following diversification formulas and popularized notions. They get paid anyway. The S&P does better than they do.

Are they just guessing? Shooting blind? Or do they have tested, reliable ways to structure portfolios that truly do minimize your risk while maximizing profit potential?

They are following old ideas. They worked before but are part of a confidence play. They don’t work well for long when everyone plays it (bubbles). The market is fed by greed and fear and they know that. So how do they alieve your fear but not your greed? They mostly care about their own paycheck. If you want to maximize your profit potential invest for yourself or become a broker and charge fees.

John, I agree. I don’t blame them for being wrong. No one can be right about the market all the time. The problem, as you have eloquently stated, is that they’re virtually PAID to be wrong. Reason:

• Analysts and fund managers who buck the crowd and miss the market get into big trouble. They may lose their job. They could be labeled “a loose cannon” and virtually barred from the Street. But …

• Analysts and fund managers that follow the crowd and miss the market suffer no such consequences. They keep their job. And if their firm has big profits, they may even earn bigger bonuses

Thus, Wall Street punishes independence and rewards crowd behavior. In this environment, even if they diligently do their homework, the conclusions and recommendations that flow from that research can rarely be balanced or objective. — Martin

Ron Ross – 01.20.10 at 11:29 AM

While I don’t “know”, I suspect that fund managers have a wide range of analytical tools at their disposal and they each have an significant dependence on the select tools that have served them well in the past. This environment makes this methodology somewhat questionable. Additionally, as with most of the comments so far, I think the professions are hearing what others are saying and then using their “gut” to sway their decisions in what they believe is the best direction.

Bottom line: technology adjusted by “gut”.

Gut feelings represent the sum total of an individual’s experience and knowledge. Gut feelings include all the essential information inputs that cannot be reduced to a number or a formula. They ARE critical to investment success.

But here’s the great dilemma, Ron: It’s those gut feelings that are the most vulnerable to influence and bias, especially the carrot-for-following-the-crowd and the stick-for-mavericks that I describe in my blog response to John above.

This is why the Wall Street “quants” — those that rely exclusively on quantitative technology and strip out gut feelings from their work — have consistently performed less badly than traditional Wall Street analysts.

But “less bad” is not exactly an adequate goal, is it? For optimal performance, what’s really needed is what I call the three “I’s” — intelligence, intuition and INDEPENDENCE — to use the best tools in an environment that’s as free of bias as one can possibly achieve. — Martin

Dave D. – 01.20.10 at 11:38 AM

They have no more idea than the rest of us and simply go with the herd while their funds go up and down along with the underlying assets and if any of them dares to go contrary then he is duly chastised. Before the 1987 crash, one fund manager (I do not recall his name) wanted to break from the herd and sell at the peak but he was blocked by his superiors so he invested heavily in puts for which he was severely reprimanded but when his fund went up while others plunged, the upper management took all the credit and I believe he left the company. So much for expertise.

Great example of exactly what I’ve been blogging about, Dave! And I can give you many, many more from the decade that just ended.

* Mark Kastan of Credit Suisse First Boston issued “buy” ratings on Winstar until the bitter end. No surprise there: Kastan’s firm owned $511 million in Winstar stock.

* An analyst at Goldman Sachs oozed 11 gloriously positive ratings on stocks that subsequently lost investors at least three-quarters of their money. He got paid $20 million for his efforts. His best performing recommendations of the year was down 71 percent; his worst was down 99.8 percent.

* Merrill Lynch’s Henry Blodget gained fame by predicting Amazon.com would hit $400 per share. It was soon selling for under $11. Blodget also predicted that Quokka Sports would hit $1,250 a share. It went bankrupt. Blodget issued and reissued strong “buy” ratings for Pets.com (out of business), eToys (lost 95 percent of its value), InfoSpace (shed 92 percent), and Barnes & Nobel.com (lost 84 percent of its value). Yet even while investors lost billions, Blodget and Merrill Lynch cleaned up — $100 million on Internet IPOs alone.

* Most bank stock analysts work for big banks or investment banks. So among the many that rated Washington Mutual, Citigroup, Bank of America,  and others that bit the dust in 2008-2009, NONE told their clients to clear out of bank stocks prior to the debacle.

Today, next to nothing has changed. Too many Wall Street analysts and pros still push stocks because of what’s in it for them — not for how it’s likely to turn out for you. — Martin
I do not question the sophistication and utility of some of the tools used on Wall Street. Over the years, for example, a lot of solid work has been done by academics on how to balance a portfolio and minimize risk. The big issue is not the tools. It’s the bias.

james – 01.20.10 at 11:41 AM

I happen to believe investor psychology drives stock prices. Most of today’s investors did not live through the crash of 1929. That is why today’s investors did not fear the run up excesses signaling the 2008-2009 collapse.

But now today’s investors have been ‘immunized’ to react strongly to the next perceived market correction. That correction started today. Investors will move away from the market RAPIDLY, since they remember how a crash feels. So rapid will be the investor reaction that the market will crash further based on this psychology.

Gold, silver, real estate, corporate debt – all asset classes are subject to this move to the downside. People will look back to see what retained value in the 2008 – 2009 market downturn and investors will buy those few asset classes…. basically the US dollar, no matter how paradoxical that might be on fundamentals.

This market downturn will be accentuated by the politics of the Brown victory in MA, since this means no more ‘bailouts’ and no more ‘too big to fail.’ Without coordinated global government spending the markets will deflate like a BALLOON.

James, one of our own, very bright experts expressed a similar view in one of our conference calls this week. In a nutshell:

• Democratic 60-vote Senate majority = the reality, or at least perception, of unbridled print-and-spend machine. But …

• 60-minus-one Senate = an sooner end, or at least a downshift, in that engine, killing the golden goose that hatched the recovery.

I agree. But there are two lingering doubts that we need to address:

• When push comes to shove, and more unemployment rears its ugly head, will Republicans vote for budget-busting stimulus just as fast as most Dems? \

• And regardless of who controls the Senate, does anyone control the Fed?

Yes, there’s a burgeoning popular outcry against deficits and Wall Street bail-outs. But I have yet to hear a peep about what really counts the most: The Fed’s nonstop, Evel-Knievel, death-defying zero-interest-rate stunt. That’s the final piece that could burst the bubble of recent months. — Martin

John Crosby – 01.20.10 at 11:41 AM

Martin, in 1988 I was working for IBM in Argentina when their inflation rate was
~2000 %/year. We got paid twice a day — at noon to buy the evening groceries, and the end of the day. You should research that era and analyze the similarities to the USA today. While inflation is not here yet, we are betting that the same process that did not stop the financial meltdown will fix the possible inflation tsunami.

As to your “fund manager” question: they use “models” which do not adequately represent all the probable and improbable conditions in the market, and then they do not stress test the models and build feedback systems sufficient to allow prompt corrective actions. Then they sub-optimize the process they built by setting limitations on where and how they can invest. It fits the definition of insanity. The operable word in your questions is “reliable” – yes, within planned parameters; no, within the real-world context.

Does that help?

That helps greatly! Thank you VERY much, John. No doubt. If the Evel-Knievel Fed keeps this up indefinitely, we’ll wind up in Argentina or Brazil of the 1970s and 1980s. You were lucky. Where I was during that era — a small town in the interior of São Paulo state, Brazil — lots of folks didn’t get paid at all … or almost as bad, got paid with three months’ delay, when the money was virtually worthless.

But deep down, I’m an optimist: I think the Fed will flop and won’t make it to that particular finish line (hyperinflation). As Claus Vogt just told us, at some point, long before then, Mssrs. Bernanke and Geithner will be slammed by a global creditor revolt — bond investors and entire countries refusing to accept more U.S. debt. They will be forced to get off the fast-track lane, slow down, or even reverse course à la Volcker. Let’s hope he’s right.

As to models, they do represent most of the probable outcomes, but as you imply, virtually none of the most important kind — the improbable ones. In our analysis, we seriously consider the improbable, and we even constantly question our own notions of the “impossible.” That doesn’t mean we can predict the events that surprise and shock everyone else. But when they do occur, at least we’re readier than most to take react and act. — Martin

+Liz – 01.20.10 at 12:33 PM

The events of the past decade clearly show that following Wall street and most mainstream financial magazines may lead to disaster.

Recall that famous Fortune magazine Oct 23, 2000 issue “Ten Stocks to Last the Decade”, listing Enron, Morgan Stanley Dean Witter and Broadcom which went from $237 to now $29 a share.

I try to follow the recommendations of Safe Money report and lately I’ve been trying to follow some of Larry Edelson’s advice in Real Wealth Report which are bit more aggressive.

Last year on Nov 25, right before Thanksgiving weekend, you sent us an alert titled Breaking news: New dollar collapse this weekend? saying the predictions in your video could start to happen as early as Monday Nov 30th which led me to invest in GLD and some mining stocks at peak prices, then the Dubai fiasco happened on Thanksgiving weekend and Gold dropped.

My mistake was to not buy gold earlier in the year when you started making recommendations and then buying in November at a panic. Now I see the wisdom of following the recommendations as they’re given and only keep about 10% in gold.

The hardest thing to do is controlling my emotions and not following the crowd.

We’re all human beings, Liz. Just as we were putting out the Thanksgiving weekend alert, the dollar had broken down dramatically, busting through key support levels. Then Dubai hit. As you may know, we’re on top of most domestic financial disasters in the making and even some international ones. But Dubai? We had no clue.

More importantly, the key take-away from your blog post is this: Even more important than the right picks or the right timing is the right AMOUNTS.

• When you overinvest in one particular asset class (in this case, gold), the inevitable errors you — or we — make are likely to be more difficult to recover from. In contrast …

• When you invest reasonable amounts across several different asset classes, those errors should be far easier to recover from, and may even be immediately offset by gains in the other areas.

Even if you don’t agree with — or remember — anything else I’ve blogged here today, never forget this one point: How MUCH to allocate to a particular asset class or investment can do more to determine success or failure than almost any other single factor. — Martin

Joe Abney – 01.20.10 at 1:30 PM

I don’t think the professionals on Wall Street have a clue. On average, they seem to be trying to find undervalued vehicles (a purely subjective exercise), but where the rubber meets the road, I think they are as clueless as all of the rest of us. I think they spread their investment capital over several hundred investments so that no one decision will torpedo their portfolio. Then I think they hope for the best. After their money is on the table, they go on as many business talk shows as possible and “cheer lead their bets” to the nines. Just my subjective opinion…….but there you have it.

Yes! One big question, though, remains: Suppose you’ve done a good job choosing the best investments, including reasonable allocations to stocks, gold, commodities, currencies and bonds? What do you do when virtually ALL asset classes are falling in synch, as they did in 2008? Possibly a good subject for my next blog! — Martin